It's that herd mentality at work again

by Vivek Kaul/DNA Money

May: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, October, March, June, December, August and February — Mark Twain

When Mark Twain said this he was probably referring to investors who tend to follow the herd, lose money and then blame the stock market for it. Experts time and again have warned the investor on this. And a similar things seems to be happening now that the Sensex has fallen by more than a thousand points in the past two days.

Benjamin Graham and David Dodd in their all time classic Security Analysis; explain the way a stock market works. They say “The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion”. Given this, at times the market moves like a herd. The interesting question to ask is “Why does this happen?”

Robert Shiller in his book, Irrational Exuberance, says, “A fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of times”.

So if everybody around is investing in a particular manner the tendency for potential investors is to do the same. Like sheep in a herd, investors find it cozy to be inside the herd rather than outside it.

Another interesting observation is the order in which investors take decisions. Ants, when they get separated from their colony, obey a simple rule: follow the ant in front of you. Much like the circular mills of the ants, investor decisions are made in a sequence. This does not always work out to their good as investors who invested in IT stocks in the year 2000 found out. And the same thing is happening now. Investors are selling everything irrespective of how good or bad the stock is.

The disciplined investor does not blindly follow the herd. He searches for stocks whose true value has not been recognized by the stock market, buys them and then waits for the stock market to recognize the right value and correct the disparity. And even if the idea is to speculate and try and ride the market, then the best way out is to earmark a certain percentage of the total investment for it. How much loss the investor should be ready to bear? If an investor can answer this question, he knows how much money he should earmark for speculation. Further, the quality of stocks is of utmost importance.

Also a disciplined investor does not invest only in stocks. He has fixed-income instruments for investment as well. Despite falling over the last two days, the Sensex has given a 70.7% return in the last one year. Expecting similar returns one year down the line is next to impossible. For that to happen, the Sensex will have to touch around 18,700.

Being a disciplined investor requires time and hard work. Most of the investors in the market operate on hearsay or on supposedly ‘insider’ information. Some of them even try to time the market. They tend to forget the golden rule of the stock markets: time in the market is more important than timing the market. And this time in the market comes from a thorough understanding of the business of the company. Like in life, there are no shortcuts to stock market investing.